Fiduciary Duties, Business Judgement Rule, Entire Fairness Standard of Review and Execpay

We will review in this post a thorough analysis by Anna Restuccia, (Hardvard Law School), on the Delaware court decision on 2018 Tesla´s compensation plan for Elon Musk. (1)

Elon Musk pay scheme as it was setup in 2018 has faced a setback as Delaware Courts have ruled board members did not act well. He was offered 12 stock option tranches (for 1% of outstanding shares each) each tranche to vest under certain cumulative conditions (50 billion in market capitalization increase each, plus some sustainable adjusted Ebitda or Revenue targets). Grant date fair value was establised at 2,6 billion, and maximum package was up to 55,8 billion. Pay opportunity was some 33 times bigger than his last pay package and some 250 times its peers higher schemes.

The plaintiff argued that this decision was taken in a conflicted controller-stockholder situation; Elon Musk held 21,9% of Tesla shares, he was the founder, powerful CEO and Chair; he also had strong ties to some directors deciding on the matter and dominated the decision-making process that led to the pay package. This implied that Courts should use an entire fairness standard, so that the defendant should prove that the plan was fair. Only if the decision had been taken by a majority of the minority shareholders on an informed way could the defendant have avoided this standard, and the plaintiff argued the decision was not informed.

Settling with Activist Investors and directors´Fiduciary Duties.

When interacting with activist investors, boards (should not we say shareholders?) often grant them some board seats in exchange for their proxy fight withdrawal. According to Neil Whoriskey, (1) this exchange means handing over something valuable, which will lead Delaware courts to apply the Unocal test, as this should be considered a defensive device, (like a poison pill, greenmail, etc). According to the Unocal test, directors detecting a threat to corporate policy or effectiveness, and introducing a proportional and reasonable defensive measure, would be granted the fit with their fiduciary duties.

The author considers the questions and certainties boards should make and have before granting partial control ot the company to a third party, in regard to the different duties.

Expropriating control: the case of Rights Offers

Leeor Ofer has just published a post in the Harvard #Corpgov blog, (1) where she summarizes her forthcoming article on “Control Expropriation via Rights offers”, (2).

A rights offer is a way to raise capital, on a current shareholding pro-rata basis, normally offering a discount on the trading price. Shareholders can then use the right and buy the shares, thus keeping their pro-rata on the company´s equity, (or sell their rights and get the discount value, if this possibility exists, and the market for the rights is efficient).

Rights offers are advantageous: (i) they may not require a shareholder approval if a previous general approval is in place; (ii) undervalued issuers may use it and avoid granting value to third parties; (iii) transaction costs are reduced; and (iv) as rights offers grant all shareholders the same options, the business judgement rule (BJR) is easily applied to these board decisions aiming at organizing a rights offer.

There is a possibility that dominant shareholders or insiders use the rights offer in order to acquire cheap stock, so as to improve the value to be captured by their investment, as small shareholders might not have enough funds, or could face uncertainty over whether the share is over or underpriced, thus using only a part of their rights to actually acquire shares, (cheap-stock tunnelling, as Fried and Spamann have recently argued (3)).

Rights offers designed to achieve control this way or the way explained below, avoiding takeover requirements and stricter fiduciary duties´control, can harm corporate governance standards.

Leeor Ofer explains that a third expropriation method may be used by dominant but non-controlling shareholders. If the offer is overpriced, (completely outside the uncertainty price area), even absent all other impediments, outsiders would avoid participating in it. This is why insiders would be able to increase their control, and afterwards extract private benefits (making the price attractive), to the detriment of minority shareholders.

Twitter, Musk and the Stakeholder Theory in practice.

Lucian A. Bebchuk, Kobi Kastiel, and Anna Toniolo have just published an interesting view on the acquisition of Twitter by Elon Musk and its consequences in terms of Corporate Governance, (1). I have recently posted some comments on the Stakeholder Theory, both presenting it and analyzing its true possibilities in practice, (some of them referring to Prof. Bebchuk articles), (2).

The battle took place in 2022, and was won by Twitter so that Musk had to keep its offer to the last USD, after trying to renegotiate the deal terms. Shareholders and probably managers obtained all their proceeds in full, …, but did other constituencies get also good results? Let´s see if this was the case.

Stock blockholders do not use to take a board seat. Why?

Alex Edmans (1) published in 2013 a study on the methods blockholders use to influence their investee firms, and signaled voice, exit (or the threat of executing them) and private benefits extraction. After reviewing the theoretical literature, he analyzes the empirical evidence, (profitability versus different blockholderism metrics). The relation  is a two-way avenue, (which affects the causal relationship identification), but both the positive governance effects of blockholders and the cost of their presence have been found.

But if this is the case, why is it that blockholders do not generally seek to take a seat on the board of companies they invest in? This is what Samed Krüger, Peter Limbach, and Paul Voß try to understand in their (2) article “Blockholder representation on the board: Theory and Evidence”. In this post we will try to expose their views.

Their first insight refers to the low costs of taking the seat, (positions are paid and eventual costs of attending meetings are low relative to amounts invested). But it is an empirical fact that blockholders do not often join boards; the ideas promoting their model and empirical research are described in aht follows:

• An indirect cost of the announcement of the representation may arise if outside shareholders generate a negative stock price effect, (this would reduce their trading options, and is hypothesis H1). This may happen as the entry reveals an agency problem, even if it also signals a governance improvement to come, (enhanced advise or monitoring). This is their hypothesis H3.
• Also, the fact that a director is granted access to insider information, the freedom to trade the company stock may be reduced.
• A seat on the board may also be considered a last resort option for the blockholder, when unseen engagement does not work.
• Moreover, freedom to exit may be reduced, so staying investee and being forced to exert effort to increase the company value may be a harm in cost and investment timings, (hypothesis H2).

Maximizing company value and fiduciary duties. Not so simple.

A lawsuit was introduced on October 3^rd 2022 against directors of Meta, (previously Facebook), adducing they breached their fiduciary duties and damaged interests of “diversified shareholders”, not in their stakes in the company, but because of alleged damages to the value of their other investments. This sounds very odd, but there is an argument. Let´s try to unravel the knot, following the Harvard Law School Forum on Corporate Governance, (1)

The complaint is based on the “shareholder primacy model”, (2) but considers not only the residual interest of common shareholders in the (maximum possible) cash flows and value to be received as common share owners, but beyond that, refers to the effect of board and directors´decisions on their other equity and debt investments, as institutional and even retail investors are generally diversified. The argument by McRitchie (the shareholder starting the procedure) refers to activities by Meta that entail political instability, damages to mental health overall and the rule of law, etc., thus endangering the value of their other investments, even if Meta value could be considered to be maximized, (all efforts by directors are guided to maximize revenue irrespective of these other public goods). The filing comes after some shareholders´proposals urging the board to consider these eventual damages were disregarded.

The filing does not consider actions by directors harmed stakeholders interests; it does not consider either that value in Meta shares was not maximized; it refers to shareholders other investments, (they are broadly diversified, as Institutional Investors -II onwards- own a majority of the market´s shares, over 75%).

Excessive Risk Taking. Why we do not learn.

In the midst of a political turmoil in the UK political arena in October 2022, a new crisis event was more or less disguised by the big picture, but is relevant enough to be mentioned, as it affects risk taking, long-term investment strategies, pension funds, employers as contributors to pension funds, etc.

It is well known that pension funds generally invest in so called safe assets a large part of their funds, in order to secure enough future cash flows to be able to serve their pension liabilities. In a QE environment, I which Central Banks provided huge amounts of cheap money in addition to reducing interest rates to historical lows, income derived from the fixed-income assets portfolios were considered to be to low to satisfy the funds´ future liabilities.

A strategy was then (again, facilitated by big finacial players, such as Blackrock, Schroeders, Legal & General Group, and others), introduced in order to maintain future income stable; LDI (liability driven investment) hedging strategies consisted in lending part of the portfolio bonds, so that hedging against falling rates effect on prices was achieved; received funds were used to reinvest in bonds, securing additional future income.

But when using this strategy, you need to be aware of the fact that sometime in the future, interest rates might rise again, as Monetary Policy could eventually change. Bets were not thinking of recent developments in energy markets, the war in Ukraine, inflation at levels not seen in decades, etc. And rates went up, and QE was to be reversed, and expectations began to reflect this. Interest rates went up in some long-term parts of the curve, and of course monetary policy started to tighten.

Hedging providers started to require additional cash from Pension Funds to cover hedging losses, and the result could not be worse, as everything joined with an irresponsible political move by the new Prime Minister Truss, which entailed a huge international bond sell-off. This altogether produced a fast and huge increase in bond yields in the markets, that could only have meant a huge iterative sell-off by Pension Funds further putting pressure on the same mechanism. Only a buyer (the Central Bank) could intervene and stop the destructive process. And it did, thus saving Pension Funds´s situation.

Some changes need to be introduced in the portfolios before the Central Bank is forced again to undo their QE, so that a huge volume of gilts (UK bonds) are released from its portfolio thus flooding the market.

I hate the sentence “this is not going to happen”, (except when the one saying it has the capacity to prevent that to happen, which normally is never).

See: https://worldnewsera.com/news/entrepreneurs/analysis-the-pension-fund-strategy-thats-plaguing-the-uk-bond-market/

Corporate Governance and the Twitter Board decision on Musk´s offer

Columbia University Law Professor Jeffrey N. Gordon recently starts a brief entry in the Oxford Law blog showing his surprise that the only reason the Twitter board apparently considered to accept Mr Musk´s offer was the interest of shareholders; moreover, he seems bewildered that public welfare, the forecast of Mr Musk´s management, the effect of the change in control on Twitter´s infrastructure had been ignored. Difficult to understand his surprise from a Shareholder primacy perspective, but mainly if fiduciary duties are considered, …, how should directors have acted? Let´s see how Prof. Gordon sees this.

According to his interpretation of Delaware corporate law, directors could have dismissed the offer on grounds of other stakeholders´interests, eventual externalities to be imposed by Mr Musk on society, or even on grounds of an eventual long-term valuation of the company which might have been considered higher than the offer price, (the last one seems to be reasonable, but board may well have analized and rejected this).

The Dodge vs Ford case: should academics keep teaching it or not?

One of the first voices that emerged against keeping the doctrine emanating from this resolution by the Michigan Supreme Court was Ms Lynn Stout, in her article “Why we should stop teaching Dodge vs Ford”, (1). Prof Bainbridge opposses to this view, (2). We will review both in what follows.

The case can be briefly described as follows: a founder and majority shareholder, (Mr Henry Ford) was sued by the Dodge brothers on the accusation that he was restricting paying dividends to shareholders even if profitability was very high; the court did not buy Mr Ford´s reasoning on preferring investing to build better and cheaper cars and pay better wages, (for their employees to be able to buy a car, for instance). And the judge stated that the purpose of a business corporation was the pursuit of profit, so that directors did not have discretion to work for alternative goals but only to select the means to pursue this one.

She asserts that this statement was not necessary and a mistake also, being strange to Corporate law.

The Shareholder Welfare Maximization Corpgov model. Can it work?

Oliver Hart and Luigi Zingales, (Harvard and Chicago) have just published an article (1) in which they promote the idea that Shareholder Value Maximization should be substituted by Shareholder Welfare Maximization as a corporate goal entailing fiduciary duties.

Their first point is examining the case for Shareholder Value Maximization: in a perfectly competitive market, an increase in the value of a firm favors shareholders whose budget restraint moves upwards, without altering other agents´ welfare as prices are not affected; so shareholders necessarily support the SVM model; the same appears to be the case if we consider the firm as a set of contracts that insulate contractors from production decisions: if a change is decided that increases shareholders´value, no stakeholder is negatively affected. Shareholders´value is the total and unique contribution of the firm to society, that is, if it dissappears, this is the value of all welfare lost.

The problems with SVM for Hart & Zingales. They see three major problems: